Plus How the CCC Affects Your Internal Rate of Return,
The Power of Leverage to Work for You and Against You, and
Effectively Manage your Enterprise by Measuring your Cash Position
Entrepreneurs intuitively understand the importance of the old saw: “Collect early, pay late.” Most SMEEs are bootstrapped and most bootstrapped SMEEs are chronically short of cash so they know in their bones how important collecting their receivables is.
What they often don’t understand is the importance of structuring their business models in the first place to create receivables which are collectible earlier in the process while at the same time negotiating, in advance, terms with their suppliers that provide them with some breathing room.
The reason you negotiate terms with suppliers in advance is so that you establish an aura of trust with them. If you tell them that you are going to pay them in, say, 90-days, then you should do your utmost to live up to that. Your suppliers are almost as important to your business’ survival as your clients.
When you also find ways to minimize your inventory, you are now well on your way to improving your cash conversion cycle even if you don’t know what that is. In fact, the CCC is one of the most important attributes of any business model and probably the most overlooked. If your CCC is negative, it means you have created a model with the happy outcome that the faster you grow your top line, the more cash you will have on hand and cash, my friend, is King (or Queen).
Here is the Golden Rule rewritten for entrepreneurs:
“He/she who has the gold, rules.”
The most basic aim of a good business model is to help you make sure that ‘the harder you work the more money you will make’. What good is a fast growing business if you go broke in the process? Don’t think that can happen to you? Sure it can if your CCC is too long.
Basically, this means that if it takes too long for you to collect your receivables or you have to pay for your inputs too early before you can deliver your product or service, your enterprise is doomed.
Some businesses grew as fast as they did (like Dell for example) because they took this to heart. Dell didn’t make anything in its early days unless they were prepaid—they kept practically nothing in inventory. Consumers and businesses pre-ordered and pre-paid for their PCs or laptops and, hence, Dell had a CCC that was negative—which meant the more they sold, the more cash they had on hand which, for a startup, is absolutely essential.
The CCC is calculated as follows:
CCC = ART + INVT – APT,
ART is Accounts Receivable at Year End multiplied by days of the year divided by Annual Sales,
INVT is Inventory at Year End multiplied by days of the year divided by COGS, Cost of Goods Sold.
APT is Accounts Payable at Year End multiplied by days of year divided by COGS.
You can read more about this at: http://www.eqjournalblog.com/?p=610. The actual calculation of CCCs are surprisingly complex and so I put a spreadsheet online to help you with this: http://www.old.dramatispersonae.org/BusinessModels/CashConversionCycleMeasurement.xls.
You may prefer using our CCC calculators in your browser, so we also put them up for you at: http://sheet.zoho.com/public/profbruce/cashconversioncyclemeasurement.
Many entrepreneurs and even some mature businesses do not give enough thought to this. We had one client of ours, a top notch advergaming firm, nearly go out of business despite: a. fantastic growth in their order book, b. a client list to die for (including several Fortune 50 and Fortune 500 companies) and c. having tremendous technology and creative resources within the business.
Each time they signed a contract, they had to hire more, highly paid tech developers and build their ‘pipeline’ to deliver the product. They forgot to get any (or at least not very much) money up front from their clients and didn’t ask for or receive progress payments when they hit certain project milestones. For complex projects that lasted a year or more, they had to wait until delivery plus 30 days to get paid—it was feast or famine for them.
As a result, they needed huge amounts of capital from their Bank (the faster they grew, the more cash they needed), which predictably enough put them in a precarious, in fact, untenable, position. I received a panic summons from them when their Bank called their loan and they were threatened with extinction. They had ten days to their next payroll which they would not have been able to meet.
We got their Bank to agree to a 90-day standstill agreement and then we asked their client base for help. Practically all of them came to their assistance.
Today, their biz model calls for 30% deposits up front when each new contract is signed and then progress payments that always put the firm out front in terms of their cashflow. They usually collect two follow-on progress payments from their clients of 30% each and, thus, just 10% is due upon final delivery plus 30 days. Essentially, they are like lawyers, paying themselves from ‘retainers’.
Their CCC went from over +300 days to a -40 days and the firm went on to do really great things.
Why did their clients agree to both a change in their billing formula and provide them with cash advances so they could pay off their bank line of credit and stay in business? Because the advergaming firm had some leverage: they have a great brand and are one of the top three advergaming firms in the world. So if they were to have folded, their clients would have had to go elsewhere; their projects would in all likelihood have been delayed since other top firms in this field all had bulging order books and quality would have suffered.
When you get in trouble, you can usually go to four places for help: your shareholders and Directors, your employees, your clients and your suppliers*. They all have a stake in your survival and will often go to great lengths to see that you do.
(* You’ll note I didn’t say you can go to your Bank. That’s because Canadian Banks have a habit of only lending to people who don’t need the money.)
Another advantage from a CCC that is less than 0 is that your IRR, Internal Rate of Return, on the equity you have invested in your business (note: this can be cash equity, in-kind equity or sweat equity) will likely increase significantly. Internal Rates of Return are highly sensitive to when positive cashflows occur. If you make a significant up front investment (negative cashflow) and it takes a long time before you see any return on that, your IRR is likely to be low or possibly negative even if the ultimate return is, in absolute terms, quite high.
This is the power of leverage and compounded interest rates– they can work for you or against you. If you can borrow 50% of a project’s cost at, say, 7% p.a. and your project’s IRR is, say, 14% then your IRR on your equity will be roughly* 21%.
(* Please don’t calculate IRRs like this. Do them properly. Here is a simple spreadsheet for you to use: http://www.old.dramatispersonae.org/IRR/SampleIRR2.xls. This is an example of a single family home bought as an investment. In one scenario, you capitalize the project with equity (your ‘down payment’) of 25%. In the other, you only put down 5%. You will see that increasing your leverage (i.e., using more debt and less equity), will boost the IRR on your equity, at least for this example.
I have some further notes that can help you with these concepts; they are posted at: http://www.old.dramatispersonae.org/IRR/IRRPowerOfLeverageGoalSetting.htm.)
Returning to our simple project above, let’s put some numbers together. To start, say, your Summer Student Painting Business, you borrow $1,000 at 7% p.a. interest only and put in $1,000 of your own money. After paying all your expenses and labour, you are left with a $280 return on capital. Of that, you have to pay $70 in interest on your loan which leaves you with a $210 return on the $1,000 of your own money you put in. So this is where I got the 21% ROE (Return on Equity) from.
Now suppose you got a $1,500 loan instead? Your interest payments will jump to $105 leaving you with just a $175 return on your equity. But hold on, you only had to put in $500 of your own money so your ROE has actually increased to a whopping 35% p.a.
Once student entrepreneurs figure this out, they soon decide that starting with zero equity or negative equity (where you end up with more cash on hand after starting the business than you had before– this is called accretive financing) is better. Not always.
If, say, your project’s return ends up being 5%, you won’t even have enough money to pay the interest on the loan you took out (which now stands at $2,000). Perhaps you decided to finance the loan with a credit card, enticed by an initial low interest rate offer of 7% from your card issuer (basically, to get you hooked on debt).
The rates on credit cards can be changed, instantly, by card issuers acting unilaterally and often without notice to you. Their right to do that is somewhere in the contract you originally signed, probably in 8-point type. Pretty soon you may be paying 28% or even 35% on your card and now you are about to enter Creditor H_ll. For more about how to creditor proof yourself, please read: http://www.eqjournalblog.com/?p=526.
So leverage can work for you or against you.
Archimedes Understood the Power of Leverage
Bootstrap entrepreneurs have to pay attention to when cashflows occur, they can’t afford to have CCCs that are greater than zero and need to have project IRRs that are significantly greater than the coupon rate on their debt. In fact, if you are an intrapreneur or product manager in a large firm, you’d better pay attention to this same set of facts. I have found that most large firms are quite disciplined about these things and they want IRRs on the firm’s cash in the range of 18% to 22% p.a., at a minimum, and you can’t get those types of returns if, say, your CCC is out of whack.
I estimated, for example, Apple’s Internal Rate of Return on the iPhone at a fantastic 288% p.a. By tweaking their business model for mobile phones, they unleashed perhaps the greatest single profit making gadget this planet has ever seen. For more on this, please see: http://www.eqjournalblog.com/?p=1714.
I would also guess that Apple knows what its CCC is for the iPhone and you can be sure it’s negative: they know how to keep inventory to a minimum as well as how to pre-sell and sell their phones before they even have to pay their suppliers.
You could also figure out that its CCC is negative just by observing things from 30,000 feet: Apple’s cash hoard on its balance sheet has grown from a big pile to a mountain. By the end of February 2010, Apple had more than $40 billion in cash on its balance sheet just two and a bit years after the introduction of the iPhone.
Alright, let’s look at a simpler example than the iPhone. Here is Acme Promotional Products and it only has one product: it sells branded pens. In fact, it only made one sale during the year and it was for 300 bucks:
1x sale of $300.00 (Branded Pens)
COGS (Cost of Goods Sold) = $200.00
1/3 is paid to their supplier of Branded Pens when the order is placed -66.67
ACME asks for and receives a 50% down payment or deposit when sale is made.
Therefore, you have:
AR = $150 (50% of $300)
INV = 0
AP = $133.33 ($200 – 66.67)
Calculating the Cash Conversion Cycle
You can see that Acme’s cash position increases as it makes each sale. Another good news story, right?
But this happy state can change in a hurry. What if their supplier wanted 100% up front with each order and their customer decided to pay them COD instead?
Now the equation looks quite different:
($300 x 365.25)/$300 + ($0 X 365.25)/$200 – ($0 x 365.25)/$200
= + 365.25 days.
In this scenario, Acme is going to starve and will be oob (out of business) in a hurry.
OK, here’s one last Acme case. Suppose their supplier’s standard contract allowed for a 10% variation in amount supplied. So Acme ends its fiscal year with some inventory. If its supplier shipped exactly 10% more product, then Acme will have $20 worth of goods on hand at year end and its AP will also be higher since it paid cash for its original order but not for the overstock. So its CCC gets even worse:
($300 x 365.25)/$300 + ($20 x 365.25)/$200 – ($20 x 365.25)/$200
= + 438.3 days.
You can read more about the Cash Conversion Cycle at: ‘Trade Credit/Supplier Credit’, http://www.eqjournalblog.com/?p=610.
How does Acme’s CCC impact their IRR? It turns out a lot.
In the first case I gave above, where they were collecting a 50% deposit from their customer but giving their supplier just a 1/3 down payment, their IRR can be estimated using the following cash flow chart. Time is measured in days.
Obviously, this is a terrific project IRR.
In case 2, where they were paying their supplier 100% up front and not receiving anything from their client until they delivered COD, their IRR plummets to just 14%.
For case 3, their IRR drops again (to 12%) because they have taken delivery of and must pay for stock overage.
From this simple example, you can begin to see the inverse relationship that exists between CCC and IRR and its importance to the overall welfare of any new enterprise.
You can also see how important it is to shorten the time between order and delivery, between paying your suppliers and receiving payment and keeping inventory on hand to a minimum.
Businesses also measure inventory turns, the number of times they can turn over inventory in a given amount of time, usually a quarter or a year.
If Acme only does one inventory turn per year, even though their IRR is terrific, it obviously isn’t a viable business since its volume is so low (one order for $300 worth of pens in a year isn’t going to cut it even if their IRR is 83% on the deal.)
If the business is a grocery store, inventory turnover is easy to understand– how many times a year does the enterprise flush its complete inventory out the door? For a software company, it seems a bit foggier. But suffice it to say here, if it is taking too long to turn out finished code and get paid for it (or start creating revenues from it), your ‘inventory’ of developers, IP, computers, furniture, chattels and fixtures is not being used productively enough by the firm.
You calculate your turnover rate for any reporting period (usually a quarter or a year) this way:
Inventory Turnover = COGS/Average Dollar Value of Inventory On Hand
COGS is the inventory cost of goods sold during a particular period.
If Acme’s COGS during a one year period is $200 and their inventory on hand is $200, they obviously have 1 inventory turnover per annum. If their COGS during a 12-month period was to increase to $2,400 and if average inventory on hand during the year was $200, they would have been able to turn their inventory over 12 times.
This example is trivial but for larger, more complex organizations, the calculations are more subtle*:
COGS = Dollar Value of Inventory at the Beginning of the Reporting Period + Dollar Value of Purchases During the Reporting Period – Dollar Value of Inventory at the End of the Reporting Period.
‘Purchases’ refers to materials and supplies bought for producing new outputs.
(* Source: Jacob J. Bierley, Jr., MBA, How to Compute Inventory Turnover, Vital Enterprises, Feb. 2008.)
What if Acme reduced the time it took to deliver its pens from 30 days to 15 or perhaps to 7 or went to overnight delivery? You can test these scenarios for yourself. Reducing delivery times not only provides Acme with the opportunity to improve its cash conversion cycle and its ROE (by increasing its IRR), it also gives them an opening to turn its inventory over more times in any given reporting period.
Inventory turns is a measure of the ‘velocity’ of a business and acts in much the same way as the velocity of money in a national economy: GDP is more influenced by the velocity of money rather than the total amount of money extant.
Many entrepreneurs and even CEOs of quite large corporations measure their businesses by tracking just three variables:
1. their bank balances at the beginning and end of each month;
2. their AR, Accounts Receivable at the beginning and end of each month; and
3. their AP, Accounts Payable at the beginning and end of each month.
Why these three variables? Because they measure cash and cash does not lie. Accounting statements are usually based on accruals.
Accrual Accounting is:
“An accounting method that measures the performance and position of a company by recognizing economic events regardless of when cash transactions occur.” (Investopedia)
So if you do a deal to ship 1,000 widgets, say, in Q1 (Quarter 1) and you ship them in that quarter but are paid in Q2, accruals accounting would allow you to recognize the revenue in Q1. Cash accounting would require you to recognize that sale when payment is received, presumably in Q2.
These differences are important because they bring interpretation and opinion into accruals accounting-based financial statements. Revenues and expenses can be moved from one quarter to the next and clever accountants can find ways to goose financial statements by, for example, advancing revenues from the next quarter to this one and delaying payables from this quarter to the next one.
This can be done quite legally under GAAP (Generally Accepted Accounting Principles) rules. But many executives are more comfortable knowing what their cash position is and how it is changing month to month. For that, you need to track just the three variables shown above.
One owner of a successful chain of pubs told me that he never accept terms from his suppliers; he always pays COD. Why? “Because when I look at my Bank balance at month end, I know that every cent in that account is mine.”
This is a $20 million per year business with 0, zip, de nada, AP.
Let’s see if we can construct a series of plausible scenarios from changes in these three variables that may help the student entrepreneur better manage and understand his or her enterprise:
( i = increasing, d = decreasing, s = static)
Bank Balance i
Sales are probably increasing with AR and AP increasing in proportion
Bank Balance i
You may be seeing more cash in your Bank Account not due to increasing sales but from a more aggressive receivables collection effort.
Bank Balance i
You may be seeing more cash in your Bank Account not due to increasing sales but from a more aggressive receivables collection effort and by delaying payments to your suppliers.
Bank Balance d
You are seeing less cash in your Bank Account perhaps not due to decreasing sales but from aging of your receivables (you are not paying enough attention to your collection efforts) while at the same time, you are continuing to pay your suppliers.
Bank Balance d
You are seeing less cash in your Bank Account even though your sales may be increasing because your receivables are aging (you are not paying enough attention to your collection efforts) and/or your CCC requires adjustment and you are not paying your suppliers as promptly as in the past. Trouble ahead.
Bank Balance d
You are seeing less cash in your Bank Account probably because your sales are dropping. You have fewer receivables and you are not paying your suppliers as promptly as in the past. Double trouble ahead.
Bank Balance i
You are seeing more cash in your Bank Account probably because your sales are increasing. You are also managing your receivables well while, at the same time, you are building trust with your supply chain partners by paying them on time or perhaps even early. Good times ahead.
There are many more scenarios that you can construct from these three variable but you should now have a bit of a feel for what you can learn by studying what is, in effect, your cash position, changes in your cash position and the the velocity of cash in your enterprise. Successful entrepreneurs get very good at this and often know more about how the business is really doing than an army of paid accountants who have many more facts at their fingertips but less knowledge.
I tell my student entrepreneurs that they can’t be dilettantish; i.e., they have to be experts in their chosen field and they have to be able to execute expertly and they have to pay attention to detail and by doing all the little things right, the big things will take care of themselves. But Michael E. Gerber (The E Myth Revisited: Why Most Small Businesses Don’t Work and What to Do About It, HarperCollins, NY. 1995) says it much better than I do:
“Those mundane and tedious little things that, when done exactly right, with the right kind of attention and intention, form in their aggregate a distinctive essence, an evanescent quality that distinguishes every great business you’ve ever done business with from its more mediocre counterparts whose owners are satisfied to simply get through the day.”
Erratum: I believe there is an error in the IRR calculations above for Acme.
A trial and error solution for IRR from first principles gives a different result for Case 1:
-$66.67 + $150.00/(1 + 1.25)**1 + (-$133.33)/(1 + 1.25)**30 + $150.00/(1 + 1.25)**31 = $0.00
-$66.67 + $66.67 – $0.00 + $0.00 = $0.00
$0.00 = $0.00, QED
This gives an IRR of 125% instead of the 83% shown above that I got from my spreadsheet. I am unclear as to why the spreadsheet produced an unreliable figure but, one thing I am sure of, is that the IRR produced from first principles is correct.
When I solve Case 2 using first principles, I get:
($200.00) $199.79 ($0.21)
irr 0.0132 1.0132
Which means the IRR for this case is 1.32% not the 14% I showed above.
For the final case, the IRR should be about 1.1% not the 12% shown above, viz:
($200.00) ($14.40) $213.72 ($0.69)
irr 0.011 1.011
The conclusions don’t change from the arguments I put forward above– the CCC is inversely related to IRR but the absolute values do.
This shows the importance of mastering the theory of any subject not just the practicum, the software or the app so you can find errors in your work.
The underlying formula for calculating IRR from first principles is based on essentially answering this question: What discount rate do you have to apply to future positive cashflows so that they exactly balance out your initial investment (negative cashflow)? The higher the discount rate you have to use, the better your project is from a financial return point of view. If you make one investment at time 0 of $X and you have positive cashflows over the next three years of $M, $N and $P and you sell the business in year four for $Q, you can solve for IRR this way using trial and error:
-$X/(1 + irr)**0 + $M/(1 + irr)**1 + $N/(1 +irr)**2 + $P/(1 + irr)**3 + $Q/(1 + irr)**4 = 0
Future cashflows can also be negative (say, when you undertake a major renovation or invest in some new technology). You can adjust the formula accordingly. Watch your signs and be aware that when cashflows transition from + to – and back again, you can get more than one IRR value that will solve the equation.
Over time, you will get a ‘feel’ for the thing and apply a reasonableness test to your results.